Your issuer client is getting ready to launch a high-yield debt offering. When you get to the office and check your messages, you learn that your client has a couple of questions about the representation in the purchase agreement that addresses Regulations T, U and X of the Board of the Federal Reserve. These Regulations are generally collectively referred to as the margin regulations. Did you just receive a “margin call?”
Before you return your client’s call, you want to get smart on the margin regulations, but you realize that you’ve only come across them in reps in purchase agreements and credit agreements, and on occasion in legal opinions. This is the first in a series of WoWs that demystify the margin regulations and highlight the key issues for you to keep in mind in your deals. In no time you’ll welcome that margin call!
The margin regulations were initially adopted in large part as a reaction to the excessive leveraged speculation in the 1920s that led to the stock market crash of 1929 and the Great Depression. Section 7 of the Exchange Act authorizes the Board of Governors of the Federal Reserve System (the Board) to prescribe rules and regulations related to margin requirements, although the Board is permitted to delegate that authority to the SEC and the CFTC. Regulations T, U and X were promulgated by the Board. The Federal Reserve Board is also responsible for interpreting the margin regulations. However, the SEC has enforcement authority over and addresses disclosure issues related to margin lending. Other self-regulatory organizations, such as the NYSE and FINRA, have also become key players in regulating margin lending.
What is the purpose of the margin regulations?
Margin limitations were initially implemented for the purpose of preventing the excessive use of credit for the purchase or carrying of securities. The federal margin regulations have served four principal purposes:
- regulating the amount of credit directed into speculative securities activities and away from other uses;
- protecting the securities markets from price fluctuations and disruptions caused by excessive securities credit;
- protecting investors from losses arising out of excessive leverage in securities transactions; and
- protecting lenders (brokers-dealers, banks and other lenders) from exposures involved in excessive margin lending to customers.
In general, the margin regulations restrict extensions of loans or other types of credit where the proceeds are used to purchase or carry certain types of publicly traded securities mainly by setting and controlling the maximum amount of credit that can be extended for those transactions. While the methods of imposing these lending limits differ depending on the type of lender involved (i.e., a broker-dealer, a bank or a non-bank lender), those limits are typically determined as a percentage of the market value of the securities being financed. Historically, permitted margin levels have ranged from 40% to 100%, depending on the events in the securities markets. Currently, an extension of credit generally may not exceed 50% of the security’s market price, though some securities are assigned much higher margin rates.1
Overview of Regulation T, U and X and preview of coming attractions
Regulation T governs the extension of credit by securities broker-dealers. Generally, a broker-dealer may extend credit to a customer in a margin account only against collateral consisting of cash or certain margin-eligible securities. A customer must maintain a margin of 50% of the current market value of margin-eligible securities financed through a margin account.
Regulation U governs the extension of credit by banks and non-bank lenders (other than broker-dealers) that extend credit for the purpose of purchasing or carrying margin stock if the credit is secured directly or indirectly by margin stock. Under Regulation U, a bank or a non-bank lender is prohibited from extending purpose credit secured directly or indirectly by margin stock in an amount that exceeds the maximum loan value of the collateral securing the credit.
Regulation X applies Regulations T and U to US persons, and foreign persons controlled by or acting on behalf of or in conjunction with US persons, who obtain credit outside the United States to purchase or carry any United States security, or obtain credit within the United States to purchase or carry any United States security. The term “United States security” includes any security (other than certain exempted securities) issued by a person incorporated under the laws of any state or whose principal place of business is in the United States. Regulation X is intended to ensure that credit obtained within or outside the United States by any US person or any foreign person controlled by a US person complies with the limitations of Regulations T and U.
In separate WoWs, we take a closer look at each of these regulations, who is subject to them and when they apply. Part Two will cover the Basics of Regulation U. Part Three will delve a little deeper into more advanced Regulation U concepts. Part Four will cover Regulation X basics. Part Five will discuss some advanced topics and lay out a few practice points. The final installment will give some final thoughts, including a few more helpful practice points.
1 The scope of this series will focus primarily on Regulation U and its application through Regulation X. The current margin rate for securities subject to these Regulations is 50%.